Abstract
This paper presents selected evidence on the impact of uncertainty and sunk costs on firms’ decisions related to entry and exit, and investment expenditures. Evidence from a large sample of US manufacturing industries shows that greater uncertainty about profits significantly lowers net entry as well as investment. The negative effects are most pronounced in industries that are dominated by small firms and have high sunk costs. We note some implications for policy related to antitrust, employment and economic stabilization.
This is a preview of subscription content, log in via an institution to check access.
Access this chapter
Tax calculation will be finalised at checkout
Purchases are for personal use only
Notes
- 1.
Pakes and Ericson (1998), Hopenhayn (1992), among others, study firm dynamics under firm-specific uncertainty and evaluate models of firm dynamics under active v. passive learning. These class of models can be better subjected to empirical evaluation using micro-datasets. Since our data is at the industry level, we are not in a position to evaluate the predictions of these models.
- 2.
Caballero and Pindyck (1996) examine the intertemporal path of a competitive industry where negative demand shocks decrease price along existing supply curve, but positive shocks may induce entry/expansion by incumbents, shifting the supply curve to the right and dampening price increase. Their evidence from a sample of U.S. manufacturing industries shows that sunk costs and industry-wide uncertainty cause the entry (investment) trigger to exceed the cost of capital.
- 3.
The above models assume perfect competition. Models of oligopolistic competition (e.g. Dixit and Pindyck, p. 309–315) highlight the dependence of outcomes on model assumptions and difficulties of arriving at clear predictions. As in models of perfect competition, the entry price exceeds the Marshallian trigger due to uncertainty and sunk costs, preserving the option value of waiting. But, for example, under simultaneous decision making, neither firm may wants to wait for fear of being preempted by its rival and losing leadership. This could lead to faster, simultaneous, entry than in the leader-follower sequential entry setting. Thus fear of pre-emption may necessitate a faster response and counteract the option value of waiting.
- 4.
In Audretsch (1995, p. 73–80), mean size of the entering firm is seven employees, varying from 4 to 15 across 2-digit industries. Audretsch (p. 159) finds 19% of exiting firms have been in the industry less than 2 years with mean size of 14 employees; for exiting firms of all ages, the mean size is 23. Dunne, Roberts and Samuelson (1988, p. 503) note that about 39% of firms exit from one Census to the next and entry cohort in each year accounts for about 16% of an industry’s output. While the number of entrants is large, their size is tiny relative to incumbents. Data indicate similar pattern for exiters.
- 5.
References
Audretsch D (1995) Innovation and industry evolution. Cambridge, MIT Press
Basu S (1996) Procyclical productivity: increasing returns or cyclical utilization? Q J Econ719–751
Bloom N, Bond S van Reenen J (2008) Uncertainty and investment dynamics. Rev Econ Stud 74(2):391–415
Brito P, Mello A (1995) Financial constraints and firm post-entry performance. Int J Ind Organiz 543–565
Caballero R, Pindyck R (1996) Investment, uncertainty and industry evolution. Int Econ Revlinebreak 641–662
Cabral L, Mata J (2003) On the evolution of the firm size distribution: facts and theory. Am Econ Rev 1075–1090
Carruth A, Dickerson A, Henley A (2001) What do we know about investment under uncertainty? J Econ Surv 14:119–154
Caves R (1998) Industrial organization and new findings on the turnover and mobility of firms.J Econ Lit 1947–1982
Chirinko R, Schaller H (1995) Why does liquidity matter in investment equations? J Money Credit Banking 27:527–548
Chirinko R (1993) Business fixed investment spending: modeling strategies, empirical results, and policy implications. J Econ Lit 31:1875–1911
Chirinko R, Schaller H (2008) The irreversibility premium. Chicago University of Illinois at Chicago
Cooley T, Quadrini V (2001) Financial markets and firm dynamics. Am Econ Rev 1286–1310
Davis S, Haltiwanger J, Schuh S (1996) Job creation and destruction. Cambridge, MIT Press
Dixit A (1989) Entry and exit decisions under uncertainty. J Polit Econ 620–38
Dixit A, Pindyck R (1994) Investment under uncertainty. Princeton, Princeton University Press
Driver C, Whelan B (2001) The effect of business risk on manufacturing investment. J Econ Behav Organiz 44:403–412
Dunne T, Roberts M, Samuelson L (1988) Patterns of entry and exit in US manufacturing industries. Rand J Econ 495–515
Evans D, Jovanovic B (1989) An estimated model of entrepreneurial choice under liquidity constraints. J Polit Econ 808–827
Fazzari S, Hubbard G, Petersen B (1988) Financing constraints and corporate investment. Brookings Pap Econ Act 141–195
Gertler M, Gilchrist S (1994) Monetary policy, business cycles, and the behavior of small manufacturing firms. Q J Econ 309–340
Ghosal V (1991) Demand uncertainty and the capital-labor ratio: evidence from the US manufacturing sector. Rev Econ Stat 73:157–161
Ghosal V (1995) Input choices under uncertainty. Econ Inq 142–158
Ghosal V (1995) Price uncertainty and output concentration. Rev Ind Organiz 10:749–767
Ghosal V (1996) Does uncertainty influence the number of firms in an industry? Econ Lett 30:229–37
Ghosal V, Loungani P (1996) Product market competition and the impact of price uncertainty on investment. J Ind Econ 217–228
Ghosal V, Loungani P (2000) The differential impact of uncertainty on investment in small and large businesses. Rev Econ Stat 338–343
Ghosal V (2006) Endemic volatility of firms and establishments. USA, Georgia Institute of Technology
Ghosal V (2007) Small is beautiful but size matters: the asymmetric impact of uncertainty and sunk costs on small and large businesses. USA, Georgia Institute of Technology
Greenwald B, Stiglitz J (1990) Macroeconomic models with equity and credit rationing. In:Hubbard, R Glenn (ed.) Asymmetric information, corporate finance, and investment. Chicago, University of Chicago Press, pp 15–42
Hartman R (1976) Factor demand with output price uncertainty. Am Econ Rev 66:675–681
Holthausen D (1976) Input choices under uncertain demand. Am Econ Rev 66:94–103
Hopenhayn H (1992) Entry, exit and firm dynamics in long run equilibrium. Econometrica1127–1150
Jovanovic B, Rousseau P (2001) Mergers and technological change. Mimeo, Chicago, University of Chicago
Kessides I (1990) Market concentration, contestability and sunk costs. Rev Econ Stat 614–622
Leahy J, Whited T (1996) The effect of uncertainty on investment: some stylized facts. J Money Credit Banking 28:64–83
Lensink R, Bo H, Sterken E (2001) Investment, capital market imperfections, and uncertainty. Edward Elgar, London
Pakes A, Ericson R (1998) Empirical implications of alternate models of firm dynamics. J Econ Theory 1–45
Stiglitz J, Weiss A (1981) Credit rationing in markets with imperfect information. Am Econ Rev 393–410
Sutton J (1991) Sunk costs and market structure. Cambridge, MIT Press
Sutton J (1997) Gibrat’s legacy. J Econ Lit 40–59
Williamson O (1988) Corporate finance and corporate governance. J Finance 567–591
Author information
Authors and Affiliations
Corresponding author
Editor information
Editors and Affiliations
Rights and permissions
Copyright information
© 2010 Springer Physica-Verlag Berlin Heidelberg
About this chapter
Cite this chapter
Ghosal, V. (2010). The Effects of Uncertainty and Sunk Costs on Firms’ Decision-Making: Evidence from Net Entry, Industry Structure and Investment Dynamics. In: Calcagnini, G., Saltari, E. (eds) The Economics of Imperfect Markets. Contributions to Economics. Physica-Verlag HD. https://doi.org/10.1007/978-3-7908-2131-4_9
Download citation
DOI: https://doi.org/10.1007/978-3-7908-2131-4_9
Published:
Publisher Name: Physica-Verlag HD
Print ISBN: 978-3-7908-2130-7
Online ISBN: 978-3-7908-2131-4
eBook Packages: Business and EconomicsEconomics and Finance (R0)